Market Timing is a Losing Bet

March 31st, 2014

By: Rob Williams | CFP ®, MSF – Chief Investment Officer

Market timers believe they can earn superior investment returns by identifying the best time to buy and sell stocks based on their analysis of economic and market indicators. Market timers make bets that they can consistently predict either the continuation or the end of a market trend. Their decisions are based only on which direction they think the market will move and not on any judgement of an asset’s fundamental value.

If they can time the market effectively, the result may be extraordinary. Ideally, their performance would reflect most of the positive returns of the market, while avoiding the downside risks of volatile investments like stocks. The concept sounds simple, but in reality it is extremely difficult. Success requires an ability to predict market fluctuations over the short term, a skill that very few have been able to demonstrate over time.

At a glance, one might think a market timer could out-perform the stock market by making accurate predictions more than 50 percent of the time. However, studies have shown that is not the case. In 1975, Nobel laureate and finance professor William Sharpe published a study titled “Likely Gains from Market Timing.” He concluded that a market timer would have to make the right call 74 percent of the time in order to equal the performance of a passive buy-and-hold strategy. His analysis did not even include the additional costs of trading and taxes that would result from a market-timing strategy. Subsequent studies arrived at similar conclusions. The market timer must have a very high success rate in order to be profitable. This is because when he is incorrect, his portfolio is left holding cash; and in a rising market, the returns on cash are much lower than those generated by stocks.

In a recent study, CXO Advisory Group tracked and graded the predictions of 68 professional forecasters from 2005 through 2012, collecting 6,582 U.S. stock market forecasts. Their study showed that the experts made correct forecasts only 47.4 percent of the time. Even the best forecaster was right less than 70 percent of the time. There are many reasons this study may not provide the full story, but the results show that these professional forecasters do not begin to approach the required 74% success rate noted above. Most professional investors concede that forecasting the economy and financial markets is extremely difficult over the long term and next to impossible over the short term. Even the chairman of the Federal Reserve, the leader of the most influential central bank in the world, admits that uncertainty is an inherent part of the job.

On the spectrum of approaches to investing, a long-term, fundamentals-based approach is at the opposite end of the spectrum from a market-timing approach. Value investing is the most straightforward approach to long-term investing. Benjamin Graham, often considered the father of value investing, once said, “if I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.”

While the odds are against market timers, there may be times when they achieve short-term success. Anyone can win a few rounds at a slot machine in Las Vegas, and a few will even win substantial amounts of money. In addition, stories about lucky investors or successful investment newsletters are more widely shared than stories about failure, romanticizing the notion of success. However, it is important to remember that the odds of successfully predicting the stock market’s short-term gyrations are extremely low.

BWFA does not ignore the economy and the market when making investment decisions. These factors are clearly relevant, even though they may be difficult to use effectively. We focus our investment efforts on selecting the best securities to hold in our client accounts for the long term. This strategy has two advantages if applied successfully: (1) Brokerage fee expenses and taxes are minimized, and (2) Downside exposure (the amount you could lose in a falling market) is lower because of the care taken in identifying fundamental value.

Favoring Mr. Graham’s approach to value investing, we recognize our limits in anticipating the market’s short-term performance and concentrate our efforts on selecting the best stocks for the long run.